Investing

TD Ameritrade Dives into Thinkorswim

You would think that the widespread market carnage over the past year or more would be enough to scare most retail investors away from risky investments like options, but that's not the signal being sent by TD Ameritrade's (AMTD) proposed cash-and-stock deal, valued at $606 million, to acquire online options broker Thinkorswim Group (SWIM), announced on Jan. 8. Ameritrade is the No. 2 online broker in terms of market capitalization, behind Charles Schwab (SCHW).

Options trading is the fastest-growing segment of the online brokerage industry, and while options certainly aren't appropriate for the unschooled or less sophisticated investors, they can help investors protect their portfolios in declining markets. And investor education tools such as those offered by Thinkorswim have helped arm more investors with the confidence they need to wade, if not dive, into these murky waters.

The fact is, options are currently the most profitable segment of the online brokerage world, and options-dedicated firms like OptionsXpress (OXPS), the largest independent options brokerage, and Thinkorswim have been doing well even through the markets' declines, according to Robert Ellis, senior vice-president of the wealth management group at Celent, a Boston-based financial research and consulting firm. Active online traders "took advantage of the market declines using options in a way that buy-and-hold investors couldn't," he says.

Options Trading Goes Mainstream

The merger of options education Web site Investools and online broker Thinkorswim nearly two years ago was greeted with a lot of skepticism in the market, but the combined company's success has been proof of the synergies that exist between education and trading activity, says Richard Fetyko, an analyst at Merriman Curhan Ford (MERR). Those synergies have enabled Thinkorswim to grow its trading volume at a faster pace than either OptionsXpress or TD Ameritrade, he adds.

"I think that combination has gotten the attention of some of the larger online brokers and also acknowledgement that options trading is no longer purely a speculative trading strategy for high-end retail investors, that it's becoming more mainstream," he says.

And that realization has companies like Ameritrade and Schwab scrambling to fortify their platforms' ability to trade options, in response to the loss of market share to stronger options platforms like Thinkorswim in recent years, he says.

One reason that options volume has grown 25% annually on average for the past 10 years is increasing awareness that options can help investors better manage their risk and add income to their portfolios, says David Fisher, chief executive at OptionsXpress. One of the more conservative strategies that beginning options investors use is the purchase of puts, which give holders the right but not the obligation to sell a stock at a specified price above where it has fallen. A second one is selling covered call contracts against existing stock positions in your portfolio to generate income even if stock prices aren't moving up, with high levels of volatility pushing up prices on calls, says Fisher. "It's easy to show people in this market how [these transactions] make sense," he says.

A Smart But Expensive Purchase

Overly risky trades such as selling naked calls without owning the underlying equities don't belong in mainstream retail investors' portfolios, but it makes sense for relatively inexperienced investors to use covered calls or some sort of options spread if they want to play the market's volatility while locking in a maximum potential loss, says Patrick O'Shaughnessy, an analyst at Raymond James (RJF).

Celent's Ellis sees the acquisition of Thinkorswim as smart but expensive, calculating that Ameritrade will be paying $6,400 for each of Thinkorswim's 94,000 customers. But the company is probably willing to pay a higher price to get the deal done quickly, and would certainly have had to pay more if it had waited, he says.

O'Shaughnessy at Raymond James regards the deal as attractive since it's expected to boost Ameritrade's earnings "pretty much from the get-go," starting in fiscal year 2010, when you take into account the planned buyback of shares to offset new shares being issued.

The $606 million acquisition price translates to a 46% premium based on the 30-day average exchange ratio used to formulate the deal. On Jan. 8, Ameritrade shares fell 7.3% before bouncing back to end 0.6% lower at 13.40, while Thinkorswim shares closed 47.6% higher at 8.34.

Consolidation for Online Brokers?

With growth in options volume outpacing equity volume for the past five years, all online brokers are very interested in options, especially since brokers can earn more on the average options trade, which garners a variable fee on each contract in addition to a flat commission, vs. only the commission on equity transactions, says Richard Repetto, an analyst at Sandler O'Neill.

Thinkorswim's clients "trade, on average, an amazing 450 times per year," driving about 60% of the broker's revenue, according to Ellis. Each trade runs between $10 and $20 per "leg," or individual contract within an options bet, and the typical options trade has three legs in the chain, he says.

Given the scale advantage in the online trading model, further consolidation "definitely makes sense," says OptionsXpress CEO Fisher. Because of the fixed costs in the clearing portion of the business, adding customers and boosting volume allow for more profitability, he says.

After a flurry of such deals earlier this decade, there's been a hiatus as stock valuations rose during the bull market that peaked in October 2007. But now that valuations have dropped substantially, Fisher says he expects to see consolidation resume.

Options: An Essential Service

As the the sole independent online options broker left standing, OptionsXpress is in a good position to benefit from further growth in options trading in the years ahead, he believes. In view of E*Trade Financial's (ETFC) troubles, Schwab is really the only potential public buyer that remains, he says. Schwab could very well make an offer, but "we are very comfortable as a stand-alone independent," he says.

OptionsXpress also clears its own trades, and its efficient trading platform and high margins, plus the successful acquisition of two smaller online brokers in the past year and a half, put it in the position to be an acquirer as much as a target, says Fisher.

It seems clear that having a robust platform for trading options will be essential if online brokers hope to retain clients and expand their business. Options trading by institutional investors will probably be flat to slightly lower this year, while trading activity by retail investors could be flat to a little higher, says O'Shaughnessy at Raymond James. "We think it's an asset class that has not been heavily adopted yet by retail investors and as the large online brokers put more emphasis on the product, interest will pick up," he says.

Right now, the companies that oversee the riskiest trades may be among the best bets in the financial-services industry.